infant-industry argument · web viewfactor proportions theory provides a good explanation of...

ECS3702 REVISION

What were the Mercantilists views on trade? How did they relate to current ideology of protectionism?

Explain who the mercantilists were.

Mercantilism was developed by writers in Europe between 1500 and 1800.

Discuss what their beliefs or ideologies were.

According to the mercantilists, trade is a zero sum game where the gains of the winners were offset by the losses of the losers.

Since not all nations could have trade surpluses at the same time, it meant one nation gained at the expense of the other nation.

Trade was based on self-interest i.e. they believed that in order to become rich and powerful a nation must export more than it imported by so doing accumulating precious metal or bullions.

Governments had to therefore ensure that exports were stimulated and imports restricted using tariffs and other trade barriers.

The excess of exports over imports led to an inflow of precious metals such as gold and silver/bullion.

There is a resurgence of neo Mercantilisms today, with nations plagued by high unemployment seeking to restrict imports in an effort to stimulate domestic production and employment.

Discuss briefly, what the criticisms of their ideas are.

the mercantilist approach failed to fully explain the welfare benefits of trade, while they themselves remained unaware as to the further effects of a trade surplus on the domestic economy

the classical theorist David Hume showed that a favourable trade balance tends to be a temporary phenomenon, as it can lead to higher domestic inflation (more money chasing the same quantity of goods).

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The resultant higher prices for domestically produced goods tend to adversely affect the international competitiveness of the economy's exports, thereby encouraging more imports into the country.

Adam Smith, also refuted the mercantilists belief that "the size of the world's economic pie is constant", and therefore a nation may only gain from trade at the expense of its trading partners. Smith argued that world output was not a fixed amount, but rather that trade between countries afforded the possibility for the latter to specialise in the production of particular goods, improving productivity through the division of labour, and ultimately leading to an increase in world output.

Furthermore, both Smith and another classical theorist, David Ricardo, argued that countries who are partners in trade can simultaneously achieve higher output levels of production and consumption as a result of free trade.

Critically evaluate Adam Smith’s theory of absolute advantage,outlining the assumptions necessary for the theory to hold in its purest form. What are the criticisms of this theory?

This question has three parts to it.

What does absolute advantage mean?

Adam Smith developed the theory of absolute advantage. Smith pointed that mutually beneficial trade between two nations is possible only if each had an absolute advantage in the production of 1 of the commodities. A nation has an absolute advantage in the production of commodity X if it can produce it more efficiently than its trading partner. By trading according to absolute advantage, complete specialization occurs

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There is also increased output as a result of specialization. Mutually beneficial trade will not occur if one nation has an absolute advantage in the production of both commodities.For trade to occur the domestic terms of trade must fall within the international terms of trade.

The theory is founded upon the following ASSUMPTIONS

Producers and consumers display rational behaviour. It’s a 2 commodity, 2 nation model. There is full employment Labour is the only factor of production Each country has a fixed endowment of resources Perfect competition exists Factors of production are mobile between the two commodities and

within the country, but not between countries There are no barriers to trade Production shoes constant returns to scale There are no transport costs The level of technology is fixed for both countries, but may differ

between them.

Criticisms

The theory has been criticised for the fact that it assumes labour is the only factor of production. This is not so as there are other factors of production such as capital, land.

The assumption of perfect competition is unrealistic. Market structures are characterised by imperfections. The labour theory of value is oversimplified. Theory assumes that trade leads to complete specialisation, however

specialisation is always incomplete Adam smith’s theory can be criticised for not being able to explain

trade of one country has an absolute advantage in the production of both commodities.

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Question 2

Critically discuss the Heckscher-Ohlin theory of international trade.

The Heckscher-Ohlin theory is also known as the factor proportions theory. It is called the Heckscher-Ohlin theory because it was developed by two Swedish economists, namely Eli Heckscher and Bertil Ohlin, in 1933.

Assumptions of the theory.

2 × 2 × 2 Model

Two countries; Two homogenous commodities; Two homogenous factor of production (FOPs):

Capital and labour; Initial levels fixed; Levels of factors available are different for each country.

Technology is the same in both countries; Constant returns to scale in production; Each commodity has a different factor intensity (i.e. one is labour

intensive, and the other is capital-intensive); Tastes/preferences are the same in both countries (i.e. demand

conditions are the same); There is perfect competition in both countries; There is domestic factor mobility, but not international factor mobility

(i.e. factors cannot move between countries); No transport costs; There are no restrictions on:

Trade;

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Determination of market price and output.

EXPLANATION OF THE THEORY

The Heckscher-Ohlin (factor proportions theory) rests on two premises: i) Commodities differ in their factor requirements; and ii) Countries differ in their factor endowments.

According to the Heckscher-Ohlin theory, a country has a comparative advantage in the production of a commodity that uses its abundant factor of production intensively. Thus, a country should export the commodity that uses its relatively abundant factor of production intensively, and import the commodity that uses its relatively scarce factor of production.

The H-O theorem extends the theory of comparative advantage by explaining the source of comparative advantage.

Countries have comparative advantage in the production of a commodity as a result of different factor endowments in the different countries.

According to the H-O theorem, international trade is due to different factor endowments.

The H-O theorem is presented in 2 theorems, the H-0 theorem and the factor proportions theorem.

The H-0 theorem states that a nation will export the commodity whose production requires the intensive use of its relatively abundant and cheap factor and import the commodity whose production requires the intensive use of its relatively scarce and expensive factor.

International trade, according to the H-O theory can be explained by factor intensity and factor abundance. Given two commodities, X and Y, and 2 factors of production, labour and capital, commodity Y is capital intensive if the K/L ratio used in the production of Y is greater than that used in the production of X.

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Therefore, Labour abundant nations will export labour intensive commodities and import capital intensive commodities, while capital abundant nations will export capital intensive commodities and import labour intensive commodities.

Factor abundance can be explained in terms of physical abundance, whereby if the total capital to total labour ratio in nation one is larger than in nation 2, then nation 1 is said to be capital intensive.

Looking at factor prices, nation 1 will be capital abundant if the r/w ratio in nation 1 is smaller than the r/w ratio in nation 2.

Criticism of the factor proportions theory

Leontief paradox.

Explains the situation where Leontief examined the trade patterns of the United States and noticed that though the US was a capital abundant nation, it imported capital intensive commodities and exported labour intensive commodities. These findings contradicted the H-O theorem.

Demand reversals

In the real world, the demand conditions between trading partners can in fact be very different, resulting in very different domestic prices in each country from those suggested by factor intensity expectations.

For example, disproportionate demand may result in a country importing a good that is capital-intensive, despite its own capital abundance.

Factor intensity reversals

Over a period of time, a commodity that was initially labour-intensive may become increasingly capital-intensive, resulting in both countries wishing to specialise in the production of such

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It does not explain intra industry trade/trade between developed countries.

Consider Germany and France. Both countries are at very similar levels of industrialisation, and their factor endowments are roughly the same. Therefore, according to factor proportions theory, there should be little or no trade between the countries. However, this is not, in fact, the case. For example, Germany exports cars to France, while France exports cars to Germany.

Factor proportions theory provides a good explanation of inter-industry trade, but is problematic with regard to intra-industry trade.

It is based on simplified assumptions that may not hold in practice.

The assumptions of perfect competition, constant returns to scale, and the same level of technology existing in both trading partners is not realistic.

Question 3

Using a well labelled diagram, explain the partial equilibrium, effects of a tariff on a small Country.

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Consider a market in a small importing country that faces an international or world price of PFT in free trade. The free trade equilibrium is depicted in the adjoining diagram where PFT is the free trade equilibrium price. At that price, domestic demand is given by DFT, domestic supply by SFT and imports by the difference DFT - SFT (the blue line in the figure).When a specific tariff is implemented by a small country it will raise the domestic price by the full value of the tariff. Suppose the price in the

importing country rises to because of the tariff. In this case the tariff

rate would be , equal to the length of the green line segment in the diagram.The following Table provides a summary of the direction and magnitude of the welfare effects to producers, consumers and the governments in the importing country. The aggregate national welfare effects is also shown. Positive welfare effects are shown in black, negative effects are shown in red.

Welfare Effects of an Import Tariff

Importing Country

Consumer Surplus

- (A + B + C + D)

Producer Surplus

+ A

Govt. Revenue

+ C

National Welfare

- B - D

Tariff Effects on:

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Importing Country Consumers - Consumers of the product in the importing country are worse-off as a result of the tariff. The increase in the domestic price of both imported goods and the domestic substitutes reduces consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.Importing Country Producers - Producers in the importing country are better-off as a result of the tariff. The increase in the price of their product increases producer surplus in the industry. The price increases also induces an increase in output of existing firms (and perhaps the addition of new firms), an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.Importing Country Government - The government receives tariff revenue as a result of the tariff. Who will benefit from the revenue depends on how the government spends it. These funds help support diverse government spending programs, therefore, someone within the country will be the likely recipient of these benefits. Refer to the Table and Figure to see how the magnitude of the tariff revenue is represented.Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government. The net effect consists of two components: a negative production efficiency loss (B), and a negative consumption efficiency loss (D). The two losses together are typically referred to as "deadweight losses." Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.Because there are only negative elements in the national welfare change, the net national welfare effect of a tariff must be negative. This means that a tariff implemented by a "small" importing country must reduce national welfare.

The general effects of a tariff

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The general effects of a tariff include, among others, an increase in the domestic price of the importable commodity, an increase in the domestic production of the tariff-distorted commodity, a decrease in the domestic consumption and a decrease in the amount of the commodity imported.

Also, when a tariff is imposed, the government collects tariff revenue, which is determined by the tariff rate andthe amount of the commodity imported.

The redistribution effects

Distribution effects relate to the redistribution of income induced by a tariff. When a tariff is imposed some economic agents will lose while others will gain. Specifically, the domestic consumers in the importing country will lose part of their consumers’ surplus due to an increase in price.

Part of the consumers’ surplus that has been lost by consumers will benefit the producer, whose producers’ surplus will increase, while another part will benefit the government in the form of government revenue. However, there is a small portion of the consumers’ surplus that has been lost to consumers but will not benefit either producers or government. The part of the consumers’ surplus that does not benefit any of the economic agents is called the ‘deadweight loss’.

ECS3702 MAY JUNE 2013 PAPER

Question 1

a. Explain the general characteristics of mercantilism. To what extent do nations today practice mercantilism?(10)

MERCANTILISM

International trade can be viewed as either as the:

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zero sum game: a situation or interaction in which one participant's gains result only from another's equivalent losses; or as a

positive sum game: a situation where the outcomes are such that the sum of winnings and losses is greater than zero. This becomes possible when the size of the pie is somehow enlarged so that there is more wealth to distribute between the parties than there was originally, or some other way is devised so everyone gets what they want or need.

The mercantilists, a group of writers during the period 1500 to 1800, believed that trade was a zero sum game.

They held that the motivation for trade was self-interest, and that the gains of the "winners" from trade were only obtained as a result of the "losses" of the losers.

The mercantilists measured the economic welfare of a country in part by the size of its foreign trade surplus. If a country exported more than it imported, then it would have a favourable balance of trade, which would result in an inflow of gold and silver from its trading partners. The latter would encourage demand within the domestic economy, increasing economic activity (output, employment etc).

To achieve such, the mercantilists argued in favour of government imposition of tariffs, etc. on imports, accompanied by simultaneous implementation of policies to encourage exports. Such strategies obviously reflect the self-interest that tended to motivate trade at the time.

To what extent do nations today practice mercantilism the mercantilist approach failed to fully explain the welfare benefits of

trade, while they themselves remained unaware as to the further effects of a trade surplus on the domestic economy

With regard to the latter, the classical theorist David Hume showed that a favourable trade balance tends to be a temporary phenomenon, as it can lead to higher domestic inflation (more money chasing the same quantity of goods).

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The resultant higher prices for domestically produced goods tends to adversely affect the international competitiveness of the economy's exports, thereby encouraging more imports into the country.

world output was not a fixed amount, but rather that trade between countries afforded the possibility for the latter to specialise in the production o

countries who are partners in trade can simultaneously achieve higher output levels of production and consumption as a result of free trade.

b. Explain the theory of Comparative advantage .assumptions and criticisms should be clearly stated.(10)

It is possible that trade may still be beneficial, even if one country has an absolute advantage over the other in the production of both goods.

Ricardo's law of comparative (or relative) advantage states that both countries will benefit from trade if the opportunity costs of production (or relative prices) differ between the two countries.

International trade will occur if:

Comparative advantages exist; and A mutually beneficial trading ratio can be established.

Possible Sources Of Comparative Advantage

Technology; Resource endowments; Differences in tastes/demands between countries.

Comparative advantage refers to the degree of advantage. Country A can have an absolute advantage over country B in the production of commodities x and y. But if the degree of advantage is greater in good x, then we say that country A

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has a comparative advantage in the production of good x, and a comparative disadvantage in the production of good y. The opposite is true for country B - it has a comparative disadvantage in the production of good x and a comparative advantage in the production of good y."

Let's assume that the world consists of two countries, A and B, that produce two commodities x and y. Suppose, as in our previous example, that the only production factor required to manufacture both goods is labour in a homogeneous form. The value of each commodity can then be determined exclusively by the amount of labour required to produce it.

Assumptions from absolute advantage to continue to apply.

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The production conditions that prevail in each country are as follows:

Country One-Person-Day Of Labour Produces:

A 60 units of good x or 20 units of good y

B 20 units of good x or 10 units of good y

In this instance, labour in country A is more productive than that in country B in the manufacture of both good x and good y, i.e. country A has an absolute advantage over country B in the production of both goods.

We should not, conclude that because country A is more efficient in the production of both goods, that it will produce both goods when trade between both countries is initiated, or that country B will produce neither good.

We will see that despite one country being absolutely more productive than another, mutually beneficial trade can - and does - still take place.

In the situation at hand, it is comparative rather than absolute advantage that is important. Referring again to the above table, we see that the degree of advantage of country A over country B is not the same for both goods. Country A has a 3:1 advantage over country B in the production of good x, but only a 2:1 advantage over country B in the production of good y.

Thus country A has a greater advantage in the production of x than in the production of y. Looked at from another point of view, country B has less of a disadvantage in the production of y than in the production of x.

country A has a comparative advantage in the production of x, and a comparative disadvantage in the production of y; and

country B has a comparative advantage in the production of y, and a comparative disadvantage in the production of x.

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If we now consider the internal situations in each country, we see that:

Country A must give up 3 units of good x in order to obtain 1 unit of good y (i.e. the opportunity cost of 1 unit of good y is 3 units of good x) or, conversely, it must give up 1/3 of a unit of good y in order to gain 1 unit of good x;

Country B must give up 2 units of good x in order to obtain 1 unit of good y (i.e. the opportunity cost of 1 unit of good y is 2 units of good x) or, conversely, it must give up 1/2 of a unit of good y in order to gain 1 unit of good x.

Opportunity cost, or the price ratio of one good to the other within each country, is a guide to comparative advantage. It requires only a comparison of the internal cost ratios between the two countries.

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Therefore, the relative cost of producing the two commodities in the two countries can be summarised as follows:

One unit of good y costs 3 units of good x in country A, and 2 units of good x in country B. Good y is therefore cheaper (in terms of good x) in country B;

One unit of good x costs 1/3 of a unit of good y in country A, and 1/2 of a unit of good y in country B. Good x is therefore cheaper (in terms of good y) in country A.

Each country should then specialise in the production of the good that it can produce most cheaply, and obtain the other through trade:

Country A will produce good x, and import good y; Country B will produce good y, and import good x.

determine the limits to mutually beneficial exchange:

Country A will be unwilling to trade 3 units of x for anything less than 1 unit of y, as it can do better at home. It would, however, be willing to trade 3 units of x for more than 1 unit of good y or, similarly, it would be willing to purchase 1 unit of y if it costs it less than 3 units of x;

Likewise, country B will be unwilling to trade 1 unit of y for anything less than 2 units of x, as it can do better at home. It would, however, be willing to trade 1 unit of y for more than 2 units of good x or, similarly, it would be willing to purchase 1 unit of x if it costs it less than 1/2 units of y.

Therefore, for trade to take place, the international terms of trade must fall between the domestic terms of trade:

For country A, three units of x must be worth more than one unit of y is worth to country B;

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For country B, one unit of y must be worth more than two units of x to country A.

In other words:

3x > y > 2x

and the international terms of trade must be such that one unit of y trades for more than 2 but less than 3 units of x. Let's choose a value of y = 2.5x, and determine the result, to see how each country gains from trade.

c. Criticisms of the factor proportions theory led to the new trade theories being developed. Name and describe any one of the alternative theories of trade (5)

ALTERNATIVE THEORIES OF TRADE

Intra-Industry Trade: countries trade the same commodities from the same industries between one another;

Inter-Industry Trade: countries trade different commodities from different industries between one another.

Consider Germany and France. Both countries are at very similar levels of industrialisation, and their factor endowments are roughly the same.

Therefore, according to factor proportions theory, there should be little or no trade between the countries. However, this is not, in fact, the case. For example, Germany exports cars to France, while France exports cars to Germany.

Factor proportions theory provides a good explanation of inter-industry trade, but is problematic with regard to intra-industry trade.

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New Trade Theories (Relating To Intra-Industry Trade)Any of the following should be explained.Product Cycle Hypothesis

This argues that highly sophisticated economies are more likely to export non-standardised goods (i.e. goods in the early stage of the product life cycle), while less sophisticated economies tend to specialise in more standardised products (i.e. goods in the latter stages of the product life cycle).

Economies Of Scale

If a country attains an initial advantage in a particular industry, then it can expand beyond the domestic market and enjoy increasing returns to scale as output expands and average production costs fall.

Product Differentiation

Germany can export cars to France, while France can export cars to Germany, as the particular type of car in each instance is aimed at a different market segment of the importing country.

Section B

Question 2

a. Define and explain the following terms

i effective rate of protection(5)

Effective Tariff Rate (Or Effective Rate Of Protection): The protection accorded to the domestic value added. This is dependent on the tariff rates levied on the final product and on the imported inputs, and also on the importance of the imported inputs with regard to the price of the final product.

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ii nominal tariff (5)

Nominal Tariff Rate: The tariff rate published in the relevant country’s tariff schedule;

The rate associated with duties imposed on goods that do not reflect price changes of the goods due to inflation, taxes, etc. Also called effective tariff rate.

b.assume SA produces shoes & R80 of leather is used in the production of each pair of shoes.assume also that free trade price of leather shoes is R100 and a 10% nominal tariff is imposed on each pair of shoes.

I. How much is the domestic value added (5)

This would be 10% x 100 = 10

Therefore price of the shoes to domestic customers would be r110.

Of this R80 is used in production,R20 is domesic value added ,R10 is the tarriff

II. How much is the effective tariff rate (5)

To calculate use g = t -a i❑-t i/1- a i❑

Where:

g = effective tariff rate

t = nominal tariff rate = 0

a i = ratio of the cost of the imported input to the price of the final commodity in the absence of tariffs = 80/100 =0.8

t i= nominal tariff rate on the imported input

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http://www.businessdictionary.com/definition/tariff-rate.html

http://www.businessdictionary.com/definition/effective.html

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http://www.businessdictionary.com/definition/inflation.html

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http://www.businessdictionary.com/definition/changes.html

http://www.businessdictionary.com/definition/labor-rate-price-variance.html

http://www.businessdictionary.com/definition/goods.html

http://www.businessdictionary.com/definition/duty.html

http://www.businessdictionary.com/definition/associated.html

http://www.businessdictionary.com/definition/rate.html

t = 10% = 0.1

g = 0.1 –(0.8)(0)/1-0.8 = 0.5 or 50%

III. Between the producers and consumers who is better of in this situation .Explain (5)

Tariff redistributes income from domestic consumers(who pay a higher price )to domestic producers (who receives a higher price)

Question 3

Use your knowledge of the classical trade theories to evaluate the following statement. “The principle of absolute advantage asserts that mutually beneficial trade can occur even if one nation is absolutely more efficient in the production of all goods. Assumptions and criticisms of theories discussed must be included. (25)

It is possible that trade may still be beneficial, even if one country has an absolute advantage over the other in the production of both goods.

Ricardo's law of comparative (or relative) advantage states that both countries will benefit from trade if the opportunity costs of production (or relative prices) differ between the two countries.

International trade will occur if:

Comparative advantages exist; and A mutually beneficial trading ratio can be established.

Possible Sources Of Comparative Advantage

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Technology; Resource endowments; Differences in tastes/demands between countries.

Comparative advantage refers to the degree of advantage. Country A can have an absolute advantage over country B in the production of commodities x and y. But if the degree of advantage is greater in good x, then we say that country A has a comparative advantage in the production of good x, and a comparative disadvantage in the production of good y. The opposite is true for country B - it has a comparative disadvantage in the production of good x and a comparative advantage in the production of good y."

Let's assume that the world consists of two countries, A and B, that produce two commodities x and y. Suppose, as in our previous example, that the only production factor required to manufacture both goods is labour in a homogeneous form. The value of each commodity can then be determined exclusively by the amount of labour required to produce it.

Assumptions from absolute advantage to continue to apply.

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We should not, conclude that because country A is more efficient in the production of both goods, that it will produce both goods when trade between both countries is initiated, or that country B will produce neither good.






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determine the limits to mutually beneficial exchange:





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In other words:

3x > y > 2x


Question 4

a. Evaluate any three of the main arguments for trade protection (15)

Infant-Industry Argument

Argues that an industry should be protected in order to allow it to grow to the point where it is big enough to compete on the world market (example of Japanese car industry).

Such protection should be temporary. As the industry “learns” how to operate efficiently, its unit costs will fall, allowing it be competitive. However, such protection can be abused, often being extended to inefficient, declining industries.

It is also argued that a production subsidy would be more apt than a tariff for, as we have seen, a tariff in effect is both a tax on consumers and a subsidy to producers.

Scientific Tariff Argument

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this type of tariff is designed to equalise wages across countries. However, it makes no allowance for productivity differentials.

Optimum Tariff Argument

The optimum tariff is held to be that rate which maximises the difference between the gain from improved terms of trade, and the loss from the reduced volume of trade.

For a small country, the optimum tariff rate is zero, because such a country cannot obtain any improvement in its terms of trade by imposing a tariff.

The case for a large country is discussed below:

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C

Free trade price

Tariff price

Export price after tariff

A B

Domestic Supply

Domestic 0 Q

P

Pft

Pd

Pt

Pft is the free trade price of a good. A tariff of t is imposed on the good, raising the domestic price to Pd, while lowering the world price to Pt.

Triangles A and B are the domestic welfare loss from the decline in the volume of trade as a result of the tariff, while rectangle C represents the improvement in the terms of trade for the large country, being the part of the tariff paid by foreign exporters.

Now, if C > (A + B), then there is a net gain to the country as a result of the implementation of the tariff. The optimum tariff will be the tariff rate that maximises this net gain i.e. the optimum tariff rate is the one that maximises:

C – (A + B)

Non-Economic Argument

For example, the argument put forward by the French government regarding the protection of their inefficient farmers is that such is necessary to preserve farming communities and maintain the rural population.

Strategic Trade Policy To Protect Oligopolistic Markets

In a perfectly competitive environment, the only possible justifications for the imposition of a tariff are:

Imposition of optimum tariff by large country to improve its terms of trade;Infant industry protection (but only if direct subsidy not feasible).

However, governments may also use tariffs/subsidies to protect large oligopolistic industries (e.g. commercial aircraft manufacturers), and to help them to increase their share of the global market at the expense of foreign competitors.

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The application of such a strategic trade policy is fraught with problems. Apart from the resultant inefficient re-allocation of the country’s resources, the cost of a subsidy may actually exceed the gains which it generates; the subsidy may attract new entrants into the industry; foreign governments may retaliate by extending similar subsidies to their own industries.

b. Name and describe any two of the main forms of non tariff barriers (10)

Import Quotas

“Direct restriction by government via a limit on permissible imports.”

An import quota thus limits the amount of a good that may be imported into the country over a specified period. If free-market demand for the good falls below the level specified by the quota, then the quota is said to be “non-binding”.

The government implements the quota by granting/selling import licenses for the relevant product, each of which allows for a limited amount to be imported by the holder.

A variation on the import quota is the “tariff quota”, where one level of tariff is applied on imports of a good up to a certain amount, with a higher tariff level than being applied to imports beyond this amount.

Although import quotas on manufactured goods are prohibited by the WTO, many developed countries impose such on the import of agricultural products.

Voluntary Export Restraints (VERs)

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These are bilateral agreements between governments to limit exports to one another. These have for the most part been phased out, and are no longer used.

International Commodity Agreements

These are agreements between countries who produce and consume a commodity. The purpose is to stabilise the price of the latter through intervention in market forces. For example:

Export restriction schemes (similar to VERs); Buffer stocks: involves attempting to maintain the price of the

commodity within a predetermined range, through the purchase and sale of the commodity from central stocks.

In both of the above figures, PE is the long-run equilibrium price determined by demand and supply curves D and S. The buffer stock management wish to limit price fluctuations to the range PF to PC. In the first figure, if supply increases to S1, then price PF can be

maintained by the buffer stock management buying the quantity ab, which is the excess supply at that price. Likewise, if supply decreases to S2, then price PC can be maintained by the buffer stock management

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0 Q

P

PC

PE

PF

D2 D D1 S

Excess supply

Excess demand

a b

c d

0 Q

P

PC

PE

PF

D S2 S S1

Excess supply

Excess demand

a b

c d

selling quantity cd of the commodity from the buffer stock, which is the excess demand at that price.

Similar situations are outlined in the second figure for changes in demand for the commodity.

International Cartels

This involves agreements between foreign companies or governments to restrict trade in a commodity. The most obvious modern day example is the oil restriction policies implemented by members of the Organisation of Petroleum Exporting Countries (OPEC).

Price is raised through the restriction of output and/or exports of the commodity, the supplier countries then gaining at the expense of consumer countries.

However, individual members of the cartel may cheat by increasing output/exports beyond previously agreed limits. Non-member producers of the commodity also tend to benefit from the strategy implemented by the cartel.

Local Content Requirements

Such regulations require that a minimum percentage of the final value of a good produced within the domestic economy must be sourced from local manufacturers. As with other protectionist measures, this can also lead to market distortions.

Border Tax Adjustments

These are used to change the price of a tradable good by an amount equal to domestic indirect taxes:

They take the form of a tax on an imported commodity, or a rebate on the export of a commodity, to put local producers on an equal footing as competitors from countries that do not impose indirect taxes.

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Anti-Dumping Import Duties

This involves the taxation of goods “dumped” in the domestic market at a lower price than that charged for the good in the country of origin. There are three general categories of “dumping”:

Sporadic dumping: irregular dumping of surplus production. Has a negligible economic effect;

Predatory dumping: Involves a large foreign company selling their product in the domestic market at a low price for the purpose of driving out competitors and increasing market share, the ultimate goal being to become a monopolist. This is the most harmful form of dumping;

Persistent dumping: occurs where a firm is a monopolist in the domestic market, but not on foreign markets. It therefore charges a higher price at home than it does abroad.

An anti-dumping import duty equal to the dumping margin may be charged on such imports. This is permitted by the WTO, if evidence of dumping can be proved

Export Subsidies

Involves a payment by government to domestic producers for every unit of a commodity exported, for the purpose of making the domestic producer’s commodity more competitive on foreign markets.

Form the point of view of the subsidising country:

The distortion of comparative advantage creates a deadweight welfare loss;

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If the country is large, the subsidy will reduce the world price for the commodity.

Form the point of view of the importing country

Its terms of trade may improve; Labour/capital in competing industries in the domestic economy may

be harmed, thereby affecting income distribution. The importing country may therefore apply a countervailing duty to offset the effect of the subsidy.

Farmers and agricultural products continue to be heavily subsidised around the world, as do industries of strategic importance (e.g. aircraft manufacturers). Export subsidies can also take the form of low interest rate loans to the foreign purchaser of the domestically-produced commodity.

Question 5

a. Explain the fundamental principles on which the World Trade organisation is based on (10)

The fundamental principles of the WTO are

The Unconditional Most Favoured Nation Principle

No discrimination is allowed between supply sources; Tariffs levied or concessions granted between two members must be

extended to all members; Members of customs unions and free-trade areas are excluded from

the above. The application of this principle has led to massive tariff reductions.

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National Treatment

Domestic and foreign firms operating in any member’s economy must be treated the same. This is referred to as the “principle of non-discrimination between foreign and domestic firms.”

Reciprocity

This principle may be simply summarised as “our country will treat your firms in the same way that your country treats our firms.”

Mutual Recognition

Countries may not discriminate against the goods/services manufactured by another member country on the basis of differing product standards.

Trade Promotion: “Fast Track Voting Procedure”

Member governments must vote on WTO-negotiated trade agreements without making amendment to the latter.

b. With regards to the regional approach explain free trade areas and economic unions stating examples of each(10)

1. Free Trade Areas (FTAs)

Involves the complete removal of trade barriers between members; Members retain their own trade barriers against non-members. An example is the North American Free Trade Area (NAFTA).

2. Economic Union

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This is the tightest form of regional integration, where fiscal and monetary policies are harmonised or unified between member states.

An example is the European Union, which has a common currency and single central bank.

c. Formation of customs unions results in both static and dynamic benefits. Explain the benefits of joining a custom union(5)

The larger the CU, the less scope there is for trade diversion. (Obviously a CU that included all countries in the world would not allow for any trade diversion);

As to the CU members, the more similar their production patterns, and the greater the differences in their respective production costs, then the greater is the scope for trade creation;

Lastly, the lower the external tariff imposed on the products of non-CU members, then the less will be the discrimination between members and non-members, and thus the smaller will be the scope for trade diversion.

Dynamic Effects

As the CU expands the market size available to member producers, then the resultant trade diversion and creation provide the latter with:

Scale economy opportunities; and Increased competition.

The scale effects may prove to be particularly beneficial to smaller member countries of the CU.

Furthermore, an increase in economic growth arising from the creation of the CU may result

in an increase in demand from within for non-member imports. This could provide some

level of compensation to non-members for losses suffered as a result of trade diversion

Question 6

Illustrate graphically and explain fully the welfare effects of international capital flows on the investing and host countries.(25)

October /November 2013

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Question 1

Briefly explain the following

a. Hecksher Ohlin theory (5)

The concept of factor intensity gives the Heckscher-Ohlin (H-O) theory its distinctive identity.This concept is a relative concept. If commodity X is capital intensive relative to commodity Y,then commodity Y is labour intensive relative to commodity X. A commodity is said to berelatively intensive in the use of a given factor if the commodity uses more units of the particularfactor per unit of the other factor than the other commodity.For example if 4 units of capital (4K) and 2 units of labour (2L) are required to produce one unitof commodity Y, the capital-labour ratio is 2. That is, 4/2 in the production of Y. If at the sametime 6 units of capital (6K) and 4 units of labour (4L) are required to produce one unit ofcommodity X, the capital-labour ratio is 1,5 that is, 6/4. In this case we say Y is capital intensiveand X is labour intensive.Figure 5.1 in the textbook illustrates the factor intensities of producing commodities X and Y inthe two nations. The K/L ratio is given by the slope of the ray through the origin. The figureshows that commodity Y is the capital intensive in both nations since its ray is steeper than thatof commodity X. Nation 2 uses a higher K/L ratio in the production of both goods because the

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relative price of capital (r/w) is lower in nation 2 than in Nation 1. If the relative price of capital decreases, producers will substitute K for L in the production of both commodities to minimize costs of production, but Y remains the K-intensive commodity.

b. Raymond Vernon ‘s theory of Product life cycle(5)

This argues that highly sophisticated economies are more likely to export non-standardised goods (i.e. goods in the early stage of the product life cycle), while less sophisticated economies tend to specialise in more standardised products (i.e. goods in the latter stages of the product life cycle).

This model is very similar to the technological gap model. It was developed by Vernon (1966).The main difference between them is that this model stresses product standardization.According to this model when a new product is introduced, it usually requires highly skilledlabour to produce. As the product matures and acquires mass acceptance, it becomesstandardized; it can be produced by mass production techniques and less skilled labour. Figure6.4 in the textbook illustrate the five stages of the product cycle model from the point of view ofthe innovating and imitating country. Over time comparative advantage in the product shifts fromthe advanced nation that originally introduced it to less advanced nations, where labour isrelatively cheap. The innovating country ends up as a net importer of the product they initiallyintroduced on the market.

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Do these alternative new trade theories completely discredit the traditional factor proportionstheory? In the textbook, the author makes the point that the two approaches explain differentaspects of international trade and are thus not mutually exclusive. The factor proportions theoryexplains inter-industry trade between developed and developing countries reasonably well,whereas the new trade theories are better equipped to explain intra-industry trade betweencountries at the same level of industrialisation. Also, the basic principle of comparativeadvantage is still at work in the new trade theories, but they can explain dynamic changes incomparative advantage better than the essentially static analysis of the factor proportionstheory. It is argued that the new trade theories are dynamic extensions of the basic H-O model.

c. Community indifference curve and its characteristics(5)

Students are expected to know indifference curves from level 2 microeconomics. We willtherefore not discuss section 3.3 of the textbook. We, however, want to highlight the fact that thehigher the indifference curve the higher the level of satisfaction it represents. The slope(absolute) of the indifference curve is known as the marginal rate of substitution (MRS). It isdefined as the amount of one good that a nation could give up for an extra unit of another goodin consumption. This is a movement along the same indifference curve. The slope of the

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indifference curve decreases (in absolute terms) as we move down the curve.

d. Difference between mercantilist theory of trade and absolute advantage theory.(5)

Adam Smith, a Scottish academic at the University of Edinburgh, advocated for free trade. In hisbook An Inquiry into the Nature and Causes of the Wealth of Nations, Smith (1776: 424)commented:It is the maxim of every prudent master of a family, never to attempt to make at homewhat it will cost him more to make than to buy ... What is prudence in the conduct of everyprivate family, can scarce be folly in that of a great kingdom. If a foreign country cansupply us with a commodity cheaper than we ourselves can make it, better buy it of themwith some part of our produce of our own industry, employed in a way in which we havesome advantage.Smith started by stating the fact that for two nations to trade with each other voluntarily, bothnations must gain. Thus, to him trade was not a zero-sum game. For Smith, the factories meantthat workers could specialise in specific tasks resulting in a considerable increase in output andthus in trade. By this process, resources are utilized in the most efficient way and the output of

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both commodities will rise. This increase in the “world” output measures the gains fromspecialisation. He reasoned that nations could also be expected to concentrate on producinggoods they make most cheaply. Accepting that cost differences would drive trade betweennations, Smith sought to explain these differences. He believed that the productivity of labourwas the main determinant of production costs. He therefore approached the determination ofabsolute advantage and trade from the supply side only and ignored the effects of changes indemand (which he believed could only be temporary).Unlike the mercantilists, Adam Smith believed that all nations would gain from free trade andtherefore strongly advocated a policy of laissez-faire. Free trade, with each nation specialising inthat commodity in which it has absolute advantage would lead to an efficient allocation of worldresources and would maximize world welfare.The principle of absolute advantage explains both the pattern of trade and the gains fromtrade. However, the classical theory is based on a number of simplifying assumptions, some ofwhich were not made explicit in the writings of Smith, Ricardo and the other classical theorists.Before explaining the pattern of trade and the gains from trade, it is worth stating these

assumptions explicitly:

e. Principles of World trade (5)

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1. The Unconditional Most Favoured Nation Principle

No discrimination is allowed between supply sources; Tariffs levied or concessions granted between two members must be

extended to all members; Members of customs unions and free-trade areas are excluded from

the above.

The application of this principle has led to massive tariff reductions.

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2. National Treatment

Domestic and foreign firms operating in any member’s economy must be treated the same. This is referred to as the “principle of non-discrimination between foreign and domestic firms.”

3. Reciprocity

This principle may be simply summarised as “our country will treat your firms in the same way that your country treats our firms.”

4. Mutual Recognition

Countries may not discriminate against the goods/services manufactured by another member country on the basis of differing product standards.

5. Trade Promotion: “Fast Track Voting Procedure”

Member governments must vote on WTO-negotiated trade agreements without making amendment to the latter

Section B

a. Assume that both South Africa and Botswana produced good A and B as follows:

SA (output /unit of labour) Botswana(output /unit of labour)

Good A 2 8Good B 1 2

a. What is the opportunity cost of good A in each countryb. What is the opportunity cost of good B in each country

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c. In which commodity does SA have Comparative advantage in.d. In which commodity does Botswana have comparative

advantage ine. What is the range for mutually beneficial trade between South

Africa and Botswana.(10)

b. Briefly discuss the differences between Adam smith’s and David Ricardo ‘s theories of trade.What are the assumptions of these theories (15)

The following necessary assumptions, although not indicated explicitly by the purveyors of classical theory, must be stated prior to a discussion of the above:

Producers and consumers are held to display rational behaviour; In this model, there are only two countries and two commodities. Each

good has identical properties, with some of each good being consumed in both countries;

There is full employment; Labour is the only factor of production. The value of a commodity is

therefore wholly based upon its labour content. For example, a good which requires six hours of labour to produce is three times as expensive as a good that takes two labour hours to produce;

Each country has a fixed endowment of resources, all units of each particular resource being identical;

Perfect competition exists; Factors of production are mobile both between the two commodities,

and within the specific country, but are not mobile between the two countries. Thus the cost of wages may differ between the two countries prior to the initiation of trade;

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There are no barriers to trade; Production is characterised by constant returns to scale. Thus the

hours of labour required to produce one unit of a product do not change, even if more of the good is produced;

There are no transport costs; The level of technology in each country is fixed, even though the

degree of technology may differ between countries.

"Comparative advantage refers to the degree of advantage. Country A can have an absolute advantage over country B in the production of commodities x and y. But if the degree of advantage is greater in good x, then we say that country A has a comparative advantage in the production of good x, and a comparative disadvantage in the production of good y. The opposite is true for country B - it has a comparative disadvantage in the production of good x and a comparative advantage in the production of good y."

This is a more complex concept, and therefore we will discuss the example given in the PT in detail (see PP. 18-24).

Let's assume that the world consists of two countries, A and B, that produce two commodities x and y. Suppose, as in our previous example, that the only production factor required to manufacture both goods is labour in a homogeneous form. The value of each commodity can then be determined exclusively by the amount of labour required to produce it. Our previous assumptions continue to apply.

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We should not, however, conclude that because country A is more efficient in the production of both goods, that it will produce both goods when trade between both countries is initiated, or that country B will produce neither good.




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We may say that:






From P. 20, P.T.:


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Now that we have established the area of specialisation that each country should adopt, we need to determine the limits to mutually beneficial exchange:




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In other words:

3x > y > 2x


Question 3

a. Discuss the empirical relevance of Heckscher Ohlin theory (10)

The empirical relevance of the H-O–S theory is discussed on pages 143-145 in the textbook.This section discusses why the returns for homogenous factors of production are not equalizedin the real world. The reason why trade has not equalized factor returns is that the simplifyingassumptions on which the theory is based do not hold in the real world.;

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b. Explain Economies of scale,intra industry trade and technological gap model as new trade theories.(15)Economies Of Scale

If a country attains an initial advantage in a particular industry, then it can expand beyond the domestic market and enjoy increasing returns to scale as output expands and average production costs fall

Assumption number 4 of the H-O model was that both goods are produced under conditions ofconstant returns to scale in the two nations. It is here argued that with increasing returns toscale mutually beneficial trade between two countries is still possible. Section 6.3 in thetextbook explains fully and also illustrates how this happens. Increasing returns to scale refersto a production situation where output grows proportionately more than the increase in inputs orfactors of production. A larger scale of operation may lead to increased labour productivity as aresult of greater division of labour and specialization. Specialized and more productivemachinery may become feasible only at a large scale of operation. Economies of scale areusually accompanied by extensive product differentiation. Some industries in certain countriesspecialise in a particular brand and acquire a comparative advantage in that segment of themarket. Figure 6.1 illustrates how complete specialization due to economies of scale results inhigher consumption possibilities in both countries.

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Intra-Industry Trade: countries trade the same commodities from the same industries between one another

Intra-industry trade arises in order to take advantage of economies of scale in production. Itbenefits consumers because of the wider range of choices at lower prices made possible byeconomies of scale in production. There are a number of differences between the H-O modeland intra-industry trade and these are discussed on page 182 in the textbook. The level of intraindustrytrade is measured by the intra-industry trade index (T):X MX MT−1−Where X and M represent respectively, the value of exports and imports of a particular industryor commodity group and the vertical bars in the numerator denote the absolute value. The valueof the index varies from zero to one. The high the T index the higher the level of intra-industrytrade in a particular industry. You do not have to go through the formal models of intra-industrytrade discussed in the textbook.

The Technological Gap ModelThis was developed by Posner (1961). It says a lot of international trade is based on the

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introduction of new products and production processes. Technological innovation will give theinnovating firm and nation a temporary monopoly based on patents and copy rights. The modelis based on the hypothesized impact of technological lags and leads in product innovation onthe pattern of international trade in manufactured products. The technological gap betweennations may be a basis of profitable trade between them. The models argue that comparativeadvantage is not static but shifts over time as a result of technical change through sustainedinnovative activity (through R & D). There is a time lag in the imitation process, bothdomestically and by foreign competitors. This is a supply-based theory and contends that thetechnologically-abundant countries would possess relative advantages in new products overless technologically developed nations

Question 4

a. Discuss differences between a tariff and a quota(15)

Import quotasA quota is a direct quantitative limit on the amount of a product that may enter a country. Importquotas on manufactured goods are prohibited by the WTO. However, many developedcountries, including the US and those of the European Union (EU), impose import quotas on

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agricultural produce. Such quotas usually accompany price support for such products, toprevent foreign suppliers benefiting from the artificially high prices in the domestic market.Farmers in countries such as the US, Japan and in the EU are politically powerful and havesuccessfully lobbied their respective governments for such protective measures. You must knowwhat the economic effects of a quota are compared to those of a tariff and be able to illustrategraphically (figure 9.1) as explained on pages 280 - 281 in the textbook. The explanation on theeffects of an import quota also compares it to an ad valorem tariff. Further comparisons arediscussed in section 9.2B

Equivalence Of A Tariff And A Quota

Requires that:

Demand and supply for the good are stationary; Perfect competition exists in all markets; Government auctions the import licenses such that the revenue

generated is the same as it would have been via imposition of a tariff on the good.

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t

D’

c d

e f i

j k

P

P1

P4

P3

P2

Domestic supply

Consider the above figure. The initial domestic demand and supply curves are given. With no international trade, the domestic price will be P1. Under free trade, the price will be P2, with ab units of the good being imported.

The introduction of a tariff t raises the domestic price to P3, with imports being reduced to gh (= ef). The same effect on domestic price and volume of exports would be obtained if the government imposed an import quota of gh.

The only difference is that the shaded area would represent government revenue in the case of a tariff, and quota rents in the case of an import quota. However, if the three conditions mentioned at the top of the page prevailed, then the effects of the tariff and quota would be identical – this is referred to as the “equivalence of a tariff and a quota”.

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P

P1

P4

P3

P2

Now consider the effect of an increase in domestic demand to D’. Under tariff t, the domestic price can never exceed the world price plus the tariff, which together make P3. Thus price remains constant despite the demand increase, and the volume of imports rises from ef to ei.

On the other hand, in the case of an import quota, the increase in demand cannot be accommodated by an increase in import quantity, which is fixed at ef. The result is a price adjustment, with domestic price rising to P4, where quantity imported remains as before at jk (= ef).

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Without necessarily having to look at all of the possible outcomes of demand and supply changes, we can generalise the results as follows, assuming the quota remains binding:

In the case of a tariff, a change in demand or supply will result in an import quantity adjustment;

In the case of an import quota, a change in demand or supply will result in an adjustment to the domestic price.

Another possible difference between a tariff and a quota is suggested by the theory of effective protection. When a quota is imposed on an imported raw material, it raises the production costs of the final good that it is used to produce. This is the same effect as would be obtained if a tariff was imposed on the imported raw material.

However, whereas import duties on raw materials may be rebated by the domestic government when the final good is exported, this never occurs in the case of import quotas.

Welfare Comparisons – Quota Versus Tariff

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D’

0 a g h b Q

P

P1

P4

P3

P2

Domestic demand

Domestic supply

tc d l

j k

e f i

m q n r

Consider the above figure. Before any change in demand or supply, the tariff t and the import quota gh cause the same deadweight loss, represented by the triangles cem and ndf.

If we now consider a rise in domestic demand, as represented by D’, then:

With tariff t, the price remains at P3 and the quantity imported rises to ei (= gb). The welfare loss then becomes the triangles cem and dli. As one can see, the approximate size of the welfare loss remains unchanged;

With import quota gh, the price rises to P4, import quantity remaining unchanged at jk (= gh). The welfare loss from the quota is much greater, consisting of the far larger triangles cqj and rlk.

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Thus the equivalence of the tariff and quota no longer applies – the quota is more economically harmful than the tariff.

Similar analyses can also be carried out for a decrease in domestic demand, and changes in domestic supply. In each instance, the equivalence of tariff t and import quota gh breaks down.

b. Discuss the scientific and infant industry arguments for protection (10)

ARGUMENTS IN FAVOUR OF PROTECTIONISM





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Question 5

a. Briefly explain and give one example of each of the main forms of economic intergration.Wheer on the list would you place Southern Africa Development Community (SADC) (15)

3. Preferential Trade Agreements (PTAs)

Tariffs and other trade barriers between members are reduced; Members retain their own trade barriers against non-members.

4. Free Trade Areas (FTAs)

Involves the complete removal of trade barriers between members; Members retain their own trade barriers against non-members.

An example is the North American Free Trade Area (NAFTA).

5. Customs Unions (CUs)

This is an FTA where members have a harmonised set of external trade policies.

An example is the Southern African Customs Union (SACU).

6. Common Market

This is a CU with freely mobile FOPs between members.

An example was the European Community (EC), prior to the further economic integration of its member states, when it then became known as the EU.

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7. Economic Union

This is the tightest form of regional integration, where fiscal and monetary policies are harmonised or unified between member states.

An example is the European Union, which has a common currency and single central bank.

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b. Discuss the trade creation and trade diversion that occur when a country joins a customs union. Can a trade diverting customs union result in trade creation (10)

THE EFFECTS OF A CUSTOMS UNION ON ALLOCATIVE EFFICIENCY AND WELFARE

Static Effects

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P

Trade Creation

Consumption Effect

Trade Diversion

P3

P2

P1

C

r qb B

Tt

Domestic demand

Domestic supply

0 Q1 Q2 Q

Let’s assume that there is a three-country world, and that countries A and B form a customs union which excludes country C. Thus A and B abolish all trade restrictions between themselves, and maintain a common external tariff against C.

To analyse the possible outcomes of such, we assume that country A is a small country, and that it faces perfectly elastic supply curves from countries B and C with respect to a hypothetical product.

The figure given above shows the domestic demand and supply for this product in country A, and the horizontal supply curves P1C of country C and P2B of country B. It is easily seen that country C is the lowest cost producer of the product.

Under free trade, price P1 will prevail, and country A will import Q1Q2 from country C.

If country A imposes a non-discriminatory tariff P1P3, then the domestic price of the good rises to P3 and domestic imports will fall to tT. However, all of the imports will still come from country C, as country B is not sufficiently competitive.

(Indeed, according to our figure, a tariff of the same amount imposed on country B’s product as that imposed on country C’s product would raise

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the price of the former’s product above the equilibrium price at which country A can produce the product itself).

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Now, if A and B form a customs union, then no tariff will be imposed on imports from B. The domestic price for the good will fall to P2, with imports increasing to bB, the latter now originating exclusively from country B.

We may analyse the results of the above using the following terms:

Trade diversion: the decline in imports from the most efficient producer;

Trade creation: the decrease in domestic output as a result of replacement by imports;

Consumption effect: the increase in domestic consumption.

From our figure, we can see that:

trade diversion is represented by tT, the decline in imports from the most efficient producer, country C;

trade creation is represented by br, the decrease in domestic output due to its replacement by imports from B; and

the consumption effect, which is favourable, is represented by the increase in domestic consumption, qB.

These three factors constitute the major static influences arising from the creation of the customs union. Whether the CU is on balance favourable to world-wide allocative efficiency is dependent upon their relative magnitudes. To be favourable, the resultant favourable consumption effect and trade creation must outweigh the negative effects of the associated trade diversion.

In reality, it is very difficult to measure such. However, we can identify certain influences likely to affect these magnitudes:

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Dynamic Effects




Furthermore, an increase in economic growth arising from the creation of the CU may result in an increase in demand from within for non-member imports. This could provide some level of compensation to non-members for losses suffered as a result of trade diversion.

Question 6

One of the most significant economic developments of the post war period is the proliferation of Multi National Corporations(MNCs).These are firms that own, control or manage

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production facilities in several counties.With regard to MNCs explain a)reasons for their existence.b)some of the problems and benefits that they create in home country.c) some of the problems they create for host country (25)

MOTIVES FOR DFI

Prospects of profit from such investment are greater than that anticipated from other uses (e.g. investment in domestic economy):

“… given the investment climate at home and abroad, expected profits (allowing for risk) from an incremental investment in foreign countries exceeded profits expected from such activity in the domestic economy.”

Factors affecting the aforementioned “climate” may include:

General level of economic activity; Existing/anticipated tax and tariff policies. International profit differentials within an industry.

Additionally, business organisations may offer reasons other than purely profit for DFI:

a) Cost Considerations (investment is “cost reducing”)

Motive is the need to obtain raw materials from abroad, as they are either unavailable at home or are available at extremely high cost. For example, investments in the extractive industries by the US. Such investment is complementary to labour/capital employed in the source economy, without which the latter would be harmed.

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Motive is to take advantage of lower labour costs in foreign countries. Resultant savings may be offset to some extent by productivity differentials. This type of investment is definitely not complementary to FOPs in the source economy

Motive may be to take advantage of policies of the foreign government favourable to DFI (e.g. special tax concessions).

b) Marketing Considerations

Familiarisation with foreign markets via exports may lead to the setting up of foreign branches;

The need to cater to the specific needs of the foreign market may result in the setting up of own distribution channels; and eventually the setting up of foreign production facilities and gearing of product line towards local tastes;

Local anti-trust laws may preclude the possibility of expansion through the purchase of local competitors.

FOREIGN INVESTMENT AND ECONOMIC WLFARE (REAL INCOME)

World Welfare

Free mobility of resources leads to the beneficial allocation of such; If capital is attracted by a higher rate of return, then it will flow from

where it is cheap (and abundant) to where it is expensive (and scarce) until returns are equalised;

Raises real total output

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Host Country

Benefits from DFI:

Real product increases as a result of the contribution to the economy of the new capital;

There is a managerial/technology transfer from the source to the host country;

External benefits may include a better trained labour force, and a newer and higher economic growth path for the host country.

Disadvantages of DFI (whether real or imagined):

Exploitation of the host country’s labour and natural resources; Research and development activities tend to be performed in the

source country, only the routine work being allocated to the foreign branch in the host country

Source Country

Advantage of DFI:

If investment is related to extractive industries, then this will provide access to raw materials not otherwise available in the domestic economy

Disadvantages of DFI:

Revenue loss to domestic government; Foreign investment increases the productivity of foreign labour, and

provides indirect benefits to the host country (e.g. labour quality and production technologies improved, establishment of superior organisational forms etc.)

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MULTINATIONAL CORPORATIONS

We have already briefly mentioned the importance of MNCs in DFI, and some of the costs/benefits that they may bring to host LDCs.

However, MNCs my also engage in certain practices that are detrimental to the host country.

Transfer Pricing

International trade theory assumes that commodities are traded on world markets between independent firms, at market-determined prices (or what is referred to as “arm’s length prices”).

However, about 25% of modern world trade in manufactured goods is conducted within firms.

A modern MNC tends to be a vertically integrated company, manufacturing – in addition to its range of final goods – a range of intermediate goods for its own production processes.

Various intermediate products (referred to as “components” may be manufactured by the MNC via affiliates and subsidiaries located in different countries. Furthermore, the assembly of the final product may be located in another country still.

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As components move through the production process, they are transferred from one subsidiary to another, and therefore become part of international trade. As a result, and as we indicated above, a large part of international trade is actually “intra-firm exchange.”

The point to note from the above is that:

“Items entering such trade will be valued according to considerations other than those determining competitive market prices.”

In this type of exchange, the pricing decisions of the MNC will be influenced by its goal of maximising its overall after-tax profit, rather than the profit of individual subsidiaries.

The prices charged by one subsidiary on sales to another subsidiary located in a different country, known as “transfer prices”, may therefore differ significantly from world prices.

Such prices will be designed to minimise overall corporate income taxes and tariff payments. If tax rates are different between the countries in which the MNCs subsidiaries are located, the MNC will shift profits from the higher to the lower tax country.

For example:

The prices of components sold by a subsidiary in a high tax country to a subsidiary in a low tax country will be decreased;

As a result, the taxable income where taxes are high will be decreased, and increased where taxes are low;

This leads to lower tax revenues for high-tax host countries.

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A similar strategy may be applied to take advantage of differing tariff rates between countries.

OCTOBER /NOVEMBER 2014

Question 1

Briefly explain the following

a. Theory of absolute advantage(5)

In "The Wealth of Nations" (1776), Adam Smith argued for the benefits of free trade between countries. Smith was writing at a time when factory-based production was becoming an increasingly important part of the total output of the UK economy, due in large part to the implementation of "division of labour"-based production practices.

Output over and above that which was required for the domestic economy could be exported. Smith argued that nations should concentrate on the production of those goods that they could produce most cheaply.

Students should note that the cost of production would also be affected by factors other than simply the production method used - the cost of labour in each country, for instance. Indeed, Smith argued that the main determinant of production costs would be the productivity of labour.

His argument regarding the determination of absolute advantage and trade was therefore primarily based upon a consideration of "supply-side factors". He tended to ignore the effect of changes in demand, which he held to be of a temporary nature.

From Smith's perspective, the principle of absolute advantage provides an explanation both of:

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the pattern of trade; and the gains from trade.

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b. Factor price equalisation theory(5)

The factor price equalisation theorem follows directly from the H-O theorem and holds onlywhen the H-O theorem holds. This theorem was developed by Paul Samuelson and hence, it is

sometimes referred to as the Heckscher-Ohlin-Samuelson (H-O-S) theorem.

The Factor price Equalisation TheoremThis theorem can be stated as follows: International trade will bring about equalisation in therelative and absolute returns to homogenous factors of production across nations. As suchinternational trade is a substitute for the international mobility of factors. This theorem says thatinternational trade will cause the wage rate of homogenous labour to be the same in all tradingnations. The same can be said for the rental price of capital (interest rate). Both relative andabsolute factor prices will be equalised.In our discussion so far, we know that in the absence of trade the relative price of commodity X(L-intensive) is lower in Nation 1 (L-abundant) than in Nation 2, while that for commodity Y (Kintensive)is lower in Nation 2 (K-abundant). Labour is relatively cheaper in Nation 1 than inNation 2 while capital is relatively cheaper in Nation 2. With trade and specialisation, Nation 1will produce more of commodity X and less of commodity Y. More labour will be demanded and

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this will raise the wage rate (w) and the relative demand of capital will fall which reduces theinterest rate (r). In Nation 2 the opposite will happen, more capital will be demanded and henceinterest rate (r) will rise. If all the assumptions hold, international trade keeps expanding untilrelative commodity prices are completely equalised, which also means equal relative factor

prices in the two nations.

c. Infant industry argument (5)





d. International cartels (5)

This involves agreements between foreign companies or governments to restrict trade in a commodity. The most obvious modern day example is

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the oil restriction policies implemented by members of the Organisation of Petroleum Exporting Countries (OPEC).

Price is raised through the restriction of output and/or exports of the commodity, the supplier countries then gaining at the expense of consumer countries.

However, individual members of the cartel may cheat by increasing output/exports beyond previously agreed limits. Non-member producers of the commodity also tend to benefit from the strategy implemented by the cartel.

e. Dynamic effects of joining a customs union(5)

THE EFFECTS OF A CUSTOMS UNION ON ALLOCATIVE EFFICIENCY AND WELFARE

Static Effects

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P

Trade Creation

Consumption Effect

Trade Diversion

P3Tt

Domestic supply

Let’s assume that there is a three-country world, and that countries A and B form a customs union which excludes country C. Thus A and B abolish all trade restrictions between themselves, and maintain a common external tariff against C.

To analyse the possible outcomes of such, we assume that country A is a small country, and that it faces perfectly elastic supply curves from countries B and C with respect to a hypothetical product.

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Consumption EffectP3

The figure given above shows the domestic demand and supply for this product in country A, and the horizontal supply curves P1C of country C and P2B of country B. It is easily seen that country C is the lowest cost producer of the product.

Under free trade, price P1 will prevail, and country A will import Q1Q2 from country C.

If country A imposes a non-discriminatory tariff P1P3, then the domestic price of the good rises to P3 and domestic imports will fall to tT. However, all of the imports will still come from country C, as country B is not sufficiently competitive.

(Indeed, according to our figure, a tariff of the same amount imposed on country B’s product as that imposed on country C’s product would raise the price of the former’s product above the equilibrium price at which country A can produce the product itself).

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Now, if A and B form a customs union, then no tariff will be imposed on imports from B. The domestic price for the good will fall to P2, with imports increasing to bB, the latter now originating exclusively from country B.

We may analyse the results of the above using the following terms:

Trade diversion: the decline in imports from the most efficient producer;

Trade creation: the decrease in domestic output as a result of replacement by imports;

Consumption effect: the increase in domestic consumption.

From our figure, we can see that:

trade diversion is represented by tT, the decline in imports from the most efficient producer, country C;

trade creation is represented by br, the decrease in domestic output due to its replacement by imports from B; and

the consumption effect, which is favourable, is represented by the increase in domestic consumption, qB.

These three factors constitute the major static influences arising from the creation of the customs union. Whether the CU is on balance favourable to world-wide allocative efficiency is dependent upon their relative magnitudes. To be favourable, the resultant favourable consumption effect and trade creation must outweigh the negative effects of the associated trade diversion.

In reality, it is very difficult to measure such. However, we can identify certain influences likely to affect these magnitudes:

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Dynamic Effects




Furthermore, an increase in economic growth arising from the creation of the CU may result in an increase in demand from within for non-member imports. This could provide some level of compensation to non-members for losses suffered as a result of trade diversion.

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Question 2

a. Discuss fully the criticisms of classical theories (8)

For example:

The theory bases trade on differences in productivity, but does not explain the reasons for such differences;

The specialisation recommendations are not realistic - no economy would choose to specialise only in the production of export goods, and ignore the production of import-competing goods;

The theory also argues that the greatest gains from trade occur between unlike countries. However, in reality the greatest proportion of international trade takes place between industrialised countries where similar social and economic conditions exist;

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Many criticisms of the model are aimed at the unrealistic assumptions upon which it is based. However, some of these can be easily modified without discarding the entire theory. For example, the assumption of only two goods can be modified to incorporate a number of goods. The latter are then ranked according to their comparative cost (see Figure 2.1, P. 15, Study Guide).

Each country will then export those goods for which it has the greatest comparative advantage, and import those for which it has the least comparative advantage.

It should be noted that comparative advantage or disadvantage in the production of goods and services is not a static thing - it will change as international patterns of trade and levels of demand change and, should exchange rates between countries change, this will affect relative prices and likewise affect demand.

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b. Discuss the criticisms of Hecksher Ohlin theory (7)

Little Relevance To The Real World

The US is capital abundant, yet its main exports are labour-intensive goods, while its main imports are capital-intensive goods. This contradiction of the theory is known as the Leontief scarce-factor paradox. The superior productivity of US workers was cited as an explanation of such.

Others argued that the contradiction was due to the fact that US tariffs protect their labour-intensive industries, and its importation of capital-intensive natural resource products.

Demand Reversal

In the real world, the demand conditions between trading partners can in fact be very different, resulting in very different domestic prices in each country from those suggested by factor intensity expectations.

For example, disproportionate demand may result in country 1 in our previous example importing a good that is capital-intensive, despite its own capital abundance.

Factor Intensity Reversal

Over a period of time, a commodity that was initially labour-intensive may become increasingly capital-intensive, resulting in both countries in our example wishing to specialise in the production of such.

Unrealistic Assumptions

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The assumptions of perfect competition, constant returns to scale, and the same level of technology existing in both trading partners is not realistic.

c. Explain the product life cycle and the technological gap models (10)

This was developed by Posner (1961). It says a lot of international trade is based on theintroduction of new products and production processes. Technological innovation will give theinnovating firm and nation a temporary monopoly based on patents and copy rights. The modelis based on the hypothesized impact of technological lags and leads in product innovation onthe pattern of international trade in manufactured products. The technological gap betweennations may be a basis of profitable trade between them. The models argue that comparativeadvantage is not static but shifts over time as a result of technical change through sustainedinnovative activity (through R & D). There is a time lag in the imitation process, bothdomestically and by foreign competitors. This is a supply-based theory and contends that thetechnologically-abundant countries would possess relative advantages in new products overless technologically developed nations.

The Product Cycle ModelThis model is very similar to the technological gap model. It was developed by Vernon (1966).

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The main difference between them is that this model stresses product standardization.According to this model when a new product is introduced, it usually requires highly skilledlabour to produce. As the product matures and acquires mass acceptance, it becomesstandardized; it can be produced by mass production techniques and less skilled labour. Figure6.4 in the textbook illustrate the five stages of the product cycle model from the point of view ofthe innovating and imitating country. Over time comparative advantage in the product shifts fromthe advanced nation that originally introduced it to less advanced nations, where labour isrelatively cheap. The innovating country ends up as a net importer of the product they initiallyintroduced on the market.Do these alternative new trade theories completely discredit the traditional factor proportionstheory? In the textbook, the author makes the point that the two approaches explain differentaspects of international trade and are thus not mutually exclusive. The factor proportions theoryexplains inter-industry trade between developed and developing countries reasonably well,whereas the new trade theories are better equipped to explain intra-industry trade betweencountries at the same level of industrialisation. Also, the basic principle of comparativeadvantage is still at work in the new trade theories, but they can explain dynamic changes incomparative advantage better than the essentially static analysis of the factor proportions

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theory. It is argued that the new trade theories are dynamic extensions of the basic H-O model.

Question 3

a. Briefly explain why increasing opportunity costs arise.Why do production frontiers of different nations have different slopes(10)

Increasing opportunity costs mean that a nation must give up more and more of one commodityto release just enough resources to produce each additional unit of another commodity. Withincreasing costs the production possibility frontier is concave from the origin. Productionpossibility frontiers reflecting the increasing opportunity costs are illustrated in figure 3.1 in thetextbook. The slope of the production possibility frontier at each point is known as the marginalrate of transformation (MRT). It refers to the amount of one commodity that a nation must giveup to produce each additional unit of the other commodity. Thus, it is the same as theopportunity cost of a good. The MRT (slope) increases as we move down (or up) the productionpossibility frontier. This shows increasing opportunity costs in each country in the production ofboth commodities. Increasing opportunity costs are explained by (1) the fact that factors ofproduction are not homogeneous and (2) are not used in the same fixed proportion. It thereforemeans that some resources are less efficient or less suited for the production of a particular

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product. Further explanations and examples are given in subsection 3.2c of the textbook.

b. Explain with aid of a diagram the gains from trade with increasing costs (15)

Illustrations of the Basis for and the Gains from Trade with Increasing CostsThe gains from trade are discussed in subsection 3.5A and illustrated in figure 3.4 in thetextbook. In section 3.4 we saw that nation 1 has comparative advantage in commodity X whilenation 2 has comparative advantage in commodity Y. In isolation the equilibrium relative price ofX is PA=1/4 in Nation 1 and PA’ = 4 in Nation 2. With trade and specialization each nationproduces more of the commodity of its comparative advantage and less of the other commodity.The international terms of trade are Px/Py=1 (PB=PB’ =1). Thus, Nation 1 moves from point A topoint B in production. Each nation will now be consuming on the international terms of trade line.Nation 1 will now consume at point E, which is on a higher indifference curve compared to point

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A. On the other hand nation 2 ends up consuming at point E’. The lines PB=PB’=1 represent theequilibrium-relative price at which trade is balanced.The equilibrium-relative price with trade is the common relative prices at which trade isbalanced. This means that at that relative price the amount of X Nation 1 wants to export will beexactly equal to the amount nation 2 wishes to import. The same can be said about commodityY. At any other relative price trade will not be balanced and that will force the relative price tochange towards its equilibrium value. Please note that the equilibrium relative price used in thisillustration was arrived at through trial and error.Unlike what we saw in the previous study unit where countries were specializing completely,under increasing costs there is incomplete specialization in production in both nations, even inthe case of a small country. This is because as nation 1 specializes in the production of X, itincurs increasing opportunity costs in producing good X. As Nation 2 specializes in producing Yit incurs increasing opportunity costs in producing Y (which means declining opportunity costs inX). Thus, as each nation specializes in the commodity of its comparative advantage, relativecommodity prices move toward each other until they are identical in both nations and thishappens before complete specialization.

Question 4

Use the figure below of an import quota to answer question 4

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b. With the imposition of a 30 unit quota on good xI. What happens to the domestic price of good x(2)

II. What happens to the domestic production of good x (2)III. What happens to the domestic consumption of good x (2)

c.uder the quota explin in your own words the resulting effects of an increase in the demand for good x (5)

d. Compare an import quota to an import tariff (8)

Question 5

With the aid of a diagram explain the process of trade creation and trade diversion.Can trade diversion result in trade creation.Your explanation must include the definition of trade creation and trade diversion.(25)

Ecs3702 October /Nov 2012

Question 1

a. Community indifference curve (5)b. Demand reversal(5)c. Tariffs (5)d. Most favoured nation principle (5)e. Multi national corporations (5)

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Section B

a. Briefly explain why increasing opportunity costs in production arise (5)

b. Briefly explain why the production possibility frontiers of different countries have different shapes (5)

c. Explain with the aid of a digram the gain frm trade (exchange and specialisation when increasing costs are present (15)

Question 3

With the aid of a diagrams fully evaluate the following statements ‘a capital abundant country will expot capital intensive goods,while a labour abundant country will expot labour intensive goods.NB state and explain any assumptions you make in order to answer the question and explain criticisms of the model.

Question 4

a. State and explain anyfive assumptions upon which the factor proportions theory is based (10)

b. Using the specific factors model explain the following statement” international trade will have an ambigious effect on the nation ‘s mobile factor,benefit the immobile factors specific to the nations export sector and harm the immobile factors specific to the nation s import competing sector or commodity.Assumptions should be clearly stated.do not use a diagram.(15)

Question 5

a. Stete and explain any five assumptions upon which the factor proportions theory is based(10)

b. Evaluate the following statement” international trade will bring about equalisation in the relative andabsolute returns to homogenous factors of production across nations (15)

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Question 6

Using correctly drawn and labelled diagrams compare and contrast the welfare effects of a tariff to the welfare effects of a quota (25)

Question 7

a. Explain the following :trade creation and trade diversion (5)b. Using a correctly drawn diagram explain the welfare effects

of a trade creating customs union (15)c. Discuss the dynamic effects from joining a customs union (5)

Ecs3702 oct/nov 2011

Question 1

a. Can the theory of absolute advantage be said to fully explain international trade?what assumptions is this theory based on and what are the limitations of this theory?

b. Using the numerical illustratin below,is it advisable for the USA to exchange 6 bushels of wheat for 6 yards of cloth?Show your calculations to motivate your answer (3)

c. If the united kingdom receives 6 bushels of wheat from the USA in exchange how many hours does the country save or how many yards of cloth does the country gain(4)

Question 2

a. Using a numerical example explain the concept of absolute advantage.Your discussion should include a discussion of the assumptions of the model as well as its criticisms (20)

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b. Explain the conditions or scenarios under which according to the theory of comaparative advantage mutually beneficial trade will occur (5)

Question 3a. Define the community indifference curve(2)b. What are the characteristics of an indifference curve(2)c. Define the marginal rate of transformation (2)d. Define marginal rate of substitution(2)e. Explain the difference between the gains from

exchange and the gains from specialisation for a small nation with the help of the production possibility frontier and community indifference curve(17)

Question 4

“the hecksher Ohlin model makes very strong predictions but Leontief showed that this model fails to explain United states trading patterns.Explain the HO model and briefly discuss the various empirical tests of the factor proportions theory (25)

Question 5

a. The Heckscher Ohlin smuelson theorem is considered to be corollary to the factor proportions theory and can hold if the factor proportions theory holds.Explain the Hecksher ohlin smuelson theorem. (10)

b. Using the specic factors model explain the following statement “international trade will have an ambigious effect on the nation ‘s mobile factor,benefit the immobile factors specific to the nations export sector and harm the immobile factors specific to the nation ‘s import competing sector or

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commodity.Assumptions should be clearly stated.Do not use a diagram.

Question 6

a. Define an import quota (4)b. With the aid of acorrectly drawn diagram examine the

partial equilibrium effects of an import quota(15)c. In what ways is an import quota similar to and different from

a tariff in terms of their effects(7)

Question 7

a. Economic intergration refers to the commercial policy of discrinatively reducing or eliminating trade barriers among nations.Discuss the forms of or degrees of regional economic intergration (15)

b. Under what conditions will a customs union result in trade creation and higher welfare levels(5)

c. Discuss the dynamic benefits from joining a customs union (5)

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infant-industry argument · web viewfactor proportions theory provides a good explanation of...

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